How to solve the debt crisis

A previous article (Real clear economics, BR, 24 Mar 2022) pointed out that governments of Pakistan have borrowed far more than the people, as ultimate borrowers, can feasibly repay. This article outlines how to begin solving the resulting debt crisis.

What can the government do? Either renegotiate another “last” IMF Programme and exacerbate political instability by putting the entire burden of future interest payments on the people (by higher taxation, energy prices, etc.). Or find ways to distribute this burden more fairly between the people and their creditors. How?

The first thing to assess is whether the state faces a liquidity or a sustainability problem? If liquidity, then additional borrowing can tide over the temporary mismatch between debt service and debt service capacity. But if the debt is unsustainable, as it clearly is, then it would be wrong to borrow more. Instead, despite its short, expected life, the government should approach the International Monetary Fund (IMF) and the World Bank (WB), in the longer-term national interest, to assist it primarily with debt relief and not more loans.

In recent times, debt restructuring has been sought—under explicit or implicit threat of default, following a build-up of arrears—in several ways: compliant (Mexico 1982-90), confrontative (Argentina 1999-2005), or negotiated (or quasi-negotiated, Greece 2010-15), among others. Naturally, we should seek restructuring with IMF/WB support.

Under its Articles, however, the IMF cannot assist countries get debt relief if their debt is sustainable. Nor lend to countries whose debt is unsustainable; unless policies to restore sustainability and market access are pursued. But sustainability is a flexible concept. So, it is now the government’s call to seek debt relief rather than loans and let IMF staff do their magic on sustainability.

Why would creditors agree to provide debt relief? Because it is crystal clear that Pakistan’s public debt is so large and growing so fast that servicing it in full, on time, is reducing investment and adversely affecting incentives to invest, reducing economic growth and ultimately, future debt servicing capacity. This puts the continuation of mutually profitable creditor-debtor relations at risk, an outcome neither party wants. A 2002 IMF report concurs: “restructuring can increase returns to all parties in cases where debt is unsustainable.”

Conceptually, restructuring is a simple affair. Every loan has a principal amount due, an interest rate, and a term over which the loan is to be repaid. Restructuring either extends the term (“reprofiling”) or reduces the interest rate (“rate-refinance”) or reduces the principal (the creditors take a “haircut”) or does some combination of the three. When this leads to a reduction in the debt burden (in the discounted present value of interest and principal payments due), it is called debt relief. (Although restructuring can also lead to an increase in the debt burden, as happened in Argentina in 2001.)

Keeping in mind multiple political realities, the government should seek to restructure sovereign domestic debt (SDD) only, at this time. The intent to service sovereign foreign debt (SFD) in full, on time, should be made clear and public. Although this article focuses on SDD, the government should give concurrent attention to the fast-looming SFD crisis.

It boggles the mind that it is official policy to incur as much foreign debt as possible. The government’s Medium-Term Debt Strategy (Draft FY20-FY23 and 2015) states this explicitly: “Government will continue to avail maximum concessional external financing” on offer. This invites catastrophe. Borrowing must be linked to returns. Space precludes saying more, but government can realise immediate savings by acting on the recommendations on SFD, among others, of the May 2021 report of the Expenditure Sub-Group of the Economic Advisory Council.

The government’s debt restructuring proposals should be embodied in a Comprehensive Economic Revival Plan, to be drawn up in one month. The current IMF Programme (due to expire on October 2, 2022) should be suspended, by mutual agreement, while IMF/WB support for debt restructuring, in the context of the proposed Plan, is sought in due course. As an unintended by-product, the government will have recourse to monetary financing of the deficit during the transition, in addition to the usual means.

Unlike external debt, SDD can be restructured through changes in domestic law, with limited impact on external reputation and access to external debt markets. It should, in principle, enjoy IMF/WB support. The principal risks arise from exposures of domestic banks, pension funds, and pensioners to SDD.

Although uncommon today, SDD restructuring is “expected to become more frequent in the future” and the IMF has recently provided a comprehensive guide to execution, based on theory and experience. While numerous details must be worked out to adapt them to our conditions, the drill consists broadly of six steps.

First, disaggregate debt stock and flows more minutely and re-classify them by currency, governing law, and citizenship and residence of holders. Second, identify exactly the domestic debt to be restructured and estimate the gross debt relief target (DRT) necessary to restore debt sustainability. Third, deduct the associated fiscal costs (recapitalisation of financial institutions, subsidies, etc.), to get net DRT; distinguished by type of creditor (local banks and non-banks), and differentiated by size classes (large and small), for each instrument (T-Bills, Bonds, and National Saving Schemes).

Fourth, assess the wider economic costs associated with restructuring. This would include the potential costs of mitigating: macro-financial impacts; adverse effects if any on market access; creditor coordination and holdout risks; and political economy considerations. Fifth, ensure that the State Bank of Pakistan, including the payments system, can operate normally throughout. Finally, determine which claims to restructure to minimize overall costs while also achieving the DRT and supporting broader macroeconomic reforms.

The greatest resistance to SDD restructuring will come from the banks. While the people of Pakistan have been driven to poverty and destitution, the top 10 banks reportedly earned Rs 1,400 billion in interest income, during each of the last two calendar years. To put this in perspective, this was nearly 60pc of total domestic interest paid by government; or nearly 11pc more than our defence expenditures; or over 26pc of total tax revenues; or some 3pc of GDP. It is only fair that banks refund some of their excess profits from the debt crisis.

How much relief can be expected? While this needs to be worked out, recent experience suggests that it should be substantial. In Cyprus (2013-15, SDD only), haircuts of 36% were achieved; in Greece (2012, SDD and SFD), in the range of 65-78%.

How long would it take? In the right hands it should be possible to complete in about four months. What is needed is a very small team of skilled economists, lawyers, and bankers with the necessary knowledge and experience, supported by the State Bank of Pakistan, and led by a strong cabinet member who enjoys the trust of all political stakeholders and through them, of the people (who bear the burden of austerity).

Managing a sovereign debt crisis is an unpleasant experience for creditors and debtors alike. If mismanaged, it can be a horribly painful experience. Yet, there is ample evidence that it can be done successfully. Especially, if confined to domestic debt. Besides, in reality, the only options are to default, then restructure, like Sri Lanka; or restructure now to avoid default.

(The writer has served as Senior Economist with the World Bank and as the Chief Economist of the Government of Pakistan)

Copyright Business Recorder, 2022